Japan's central bank is facing a debt crisis

posted on February 1, 2016

According to conventional economic theory, the monetisation of government debt is a recipe for fiscal profligacy and hyperinflation. It should be the last thing any credible central bank turns its hand to. But this is precisely what the Bank of Japan has been doing for the past three years.

As part of its quantitative and qualitative monetary easing (QQE), the BoJ has already amassed more than ¥300 trillion ($3.5 trillion) of Japanese government bonds. The bank has pledged to continue this gigantic monetary easing program until the rate of inflation rises to 2 per cent. But on Friday it shifted course to also embrace a policy of limited negative interest rates.

According to the BoJ, the Japanese economy is trapped in a vicious cycle of deflation and stagnation - escaping from this requires bold attempts on both monetary and fiscal fronts. QQE is an integral part of Abenomics, Prime Minister Shinzo Abe's comprehensive economic revitalisation package. But the idea that Japan needs a radical policy to break out of its deflationary malaise is questionable.

It is hard to believe that Japan's deflation is so bad that the BoJ has been licensed to engage in a policy that openly challenges basic economic theory. Not only has Japan's deflation been quantitatively miniscule - the average inflation rate for the past 15 years is -0.1 per cent - but much of this deflation is a statistical illusion. Japan's consumer price statistics tend to overestimate quality improvement in new products, which has the effect of dampening the official rate of inflation.

Unfortunately the solvency of the Japanese government is increasingly in doubt. Not only is Japan's public debt staggeringly large - it now exceeds 240 per cent of its GDP - but the government is incurring massive fiscal deficits each year. Worse yet, these deficits are often more structural than cyclical, reflecting Japan's ballooning social security expenditure.

Japanese society is ageing rapidly. Reducing social security programs, such as pensions and elderly care services, would be economically difficult and politically suicidal. The Abe administration is making use of a temporary increase in tax revenue not to retire existing debt, but to increase expenditure on services benefiting the elderly.